Predatory Pricing

by Don Boudreaux on April 6, 2011

in Antitrust, Myths and Fallacies, Prices, Seen and Unseen

Yesterday in my Masters-level microecon-theory course I discussed with my students the theory and practice of “predatory pricing.”

Here’s a summary of my views on that unicorn.

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{ 87 comments }

SheetWise April 6, 2011 at 1:15 am

I read your acknowledgment that predatory pricing can exist, but cannot continue to exist if the Bank of the (P)redator along with their willing to (L)ose < the (C)ompetitors Bank plus their ability to (B)orrow less (D)ebt service. So if (P-L)<(C+B-D) predation fails.

If I was playing this game, I would use a long timeline and want to know the resolve of my opponent. I would also want to know what market changes they anticipated that I did not.

Before borrowing I would suggest corporate espionage — and if I didn't, the lender probably would.

SheetWise April 6, 2011 at 1:35 am

To be more clear — there are many people who do what I do. My main function is to stem the flow of information from the enterprise, but I am often times tasked, in SARBOX due diligence work, to collect information from competing enterprises. I’m comfortable performing both of these functions, with the understanding that under professional and ethical rules I must recuse myself if I have a conflict … in which case I have signaled my hand, and the client can use my recusal as a “first approximation” (thanks Russ) of where they should begin their due diligence work.

Nothing is as simple as it looks.

DG Lesvic April 6, 2011 at 2:10 am

‘Those who invested their reserves in price war while others invested in better means of production would lose both their reserves and the war.”

From The Myth of the Administered Market at

http://econotrashtalk.org/#The_Myth_of_the_Administered_Market

SheetWise April 6, 2011 at 2:16 am

“I would also want to know what market changes they anticipated that I did not.”

– SheetWise

vikingvista April 6, 2011 at 2:21 am

The fallacy of predatory pricing is at the heart of the Marxian fantasy that capitalism naturally tends to monopoly. There are numerous reasons why it is nonsense, and you hit the major ones.

I would add that competition doesn’t end once a monopoly is achieved. Even in the unlikely event that a firm achieved monopoly in spite of such asymmetric losses, its subsequent debt position would make it noncompetitive against any other competing firm trying to enter the market. And the more it attempted to suppress competitors, the less competitive, and less able to suppress competitors, it would become. It would never find the opportunity to return to profitability.

There is a problem with monopoly. But capitalism is the solution to it.

SheetWise April 6, 2011 at 2:36 am

I generally agree — on the reason we may disagree — but we generally agree. My position is that information is difficult to contain, and whatever efficiencies have beat your competitors, they will be duplicated and/or improved on in short time.

Where I disagree is in technologies that, in market terminology, have a short life. One example would be Germany and the US developing nuclear weapons during WWII. First to arrive is probably the winner.

SheetWise April 6, 2011 at 2:43 am

Admins: There are so many ways you can fix these errors short of posters reviewing every keystroke. One is a preview screen, this is trivial. Second is an edit function — less trivial, but you’ll learn something. Third is an HTML validator — this is probably your best option, although I don’t know how you could make it work without a preview. So why don’t you try using a validator with a preview function — in which case you can fell comfortable using underlines, strikes, quotes, and even anchors! All sorts of fun HTML attributes.

vikingvista April 6, 2011 at 12:55 pm

“Where I disagree is in technologies that, in market terminology, have a short life. One example would be Germany and the US developing nuclear weapons during WWII.”

With that example, I’m not sure what market you are talking about. Building a weapon and destroying your enemy with it I think is something different. I can certainly imagine monopolies being permanently maintained through aggression. They are called governments.

But where the only available tools are voluntary trade, the issue is different. If you are not a monopoly, but you want to become one through voluntary trade, then you are probably wanting the impossible, short of a natural disaster wiping out your competition.

If you are already a monopoly, and you are better than everyone else at what you do, you may maintain your monopoly for a while, but as soon as you stop being the best, you are likely to lose your monopoly status.

I’m not sure a competitive monopoly–a solitary supplier that must compete against POTENTIAL start-ups–is really properly called a “monopoly”. “Monopoly” seems to me to connote not just singularity, but an absence of competition. Profit seekers chomping at the bit to gobble up some of your market share is not really an absence of competition.

DG Lesvic April 6, 2011 at 4:01 am

There is no problem with free market monopoly.

The suppliers “have but one logical presumption: they profit, with or without competition, only so far as they satisfy the consumers.”

From The Myth of the Administered Market

See the link above

kyle8 April 6, 2011 at 6:52 am

But more to the point, can free market monopoly even exist? I mean, outside of a very very limited time scale.

Historically monopolies only occur with government contrivance. Combinations can exist, but always fall apart over time as the companies discover that they can increase their market share significantly by cheating.

DG Lesvic April 6, 2011 at 11:15 am

That is not more but less to the point.

Yes, free market monopoly is conceivable, and, does in fact exist, and it is the absence of it that is inconceivable.

But so what, if for free market monopolistic and competitive supplier alike, there is but one logical conclusion: he profits only so far as he satisfies the consumers.

That is the point that all the commenters above and below are missing.

Congratulations to you all.

Surfisto April 6, 2011 at 12:26 pm

Hi DG,
Could you give an company example of a monopoly.
Regards
John

kyle8 April 6, 2011 at 5:34 pm

You seem very smug for a man who just wrote something that is meaningless.

vikingvista April 6, 2011 at 12:41 pm

“outside of a very very limited time scale”

It matters how one defines monopoly. Obviously, as you point out, a sole supplier of something can and does occur all the time, at least briefly, without anyone complaining. For a libertarian, the issue is coercion, so coercive monopoly is what matters. For a marxian, voluntaryism leads naturally to permanent monopoly, so sustainable monopoly is what matters.

I believe economics shows that only coercive monopolies are sustainable.

Michael April 7, 2011 at 4:04 pm

It’s amusing that you quote yourself as an authority.

SheetWise April 6, 2011 at 2:42 pm

How did a conversation on predatory pricing get mired into a discussion of monopoly? The establishment of a monopoly is certainly not necessary to profit from predatory pricing (based upon my assumption that you CAN profit from predatory pricing).

vikingvista April 6, 2011 at 3:04 pm

It is considered a monopolistic practice. It is a means by which economic illiterates claim capitalism naturally tends toward monopoly. And it is one excuse used for anti-trust government aggression. Nobody advocates anti-trust government aggression on the basis that it is merely profitable.

dan April 7, 2011 at 3:34 pm

Any monopoly is likely to occur by the assistance of Govt interventionism and corruption.

Methinks1776 April 6, 2011 at 5:22 am

Government should permanently and uncompromisingly resist all temptation to stop firms from cutting prices.

Like asking a pig to stop rolling in mud.

Don Boudreaux April 6, 2011 at 7:19 am

Alas, yes.

Krishnan April 6, 2011 at 7:21 am

GOVERNMENT picking winners and losers is always a lose, lose proposition for consumers … Instead of using anti trust to force some producers to keep their prices high, GOVERNMENT can provide public funds to a company favored by the administration which can then use those funds to drive their competitors out of business … We are indeed watching GE (the ideal Crony Industrialist) use public funds and access to public officials to enlarge their own assets at the expense of perhaps others who are naive enough to rely on the market … I imagine in a few years, if unchecked, GE will be the market leader in some “renewable technology” and we the consumers will pay HIGH prices because using public funds GE would have driven others off the market.

So yes, it is lunacy to interfere with the price mechanism and the ability of the capital markets to pick winners and losers … Let people decide – not the few people who somehow have found the levers of power and abuse it.

Dave April 6, 2011 at 8:57 am

I believe in unicorns!

Frank33328 April 6, 2011 at 10:02 am

What about “dumping,” the practice of one country trying to gain a global monopoly on a certain commodity/industry by subsidizing its domestic industry and allowing it to run at a loss (indefinitely?). If the industry/commodity in the “prey” country is one that has a high barrier to entry, either it is capital intensive or has a long lead-time to develop, then is it conceivable that this strategy would work?

vikingvista April 6, 2011 at 1:01 pm

Nobody disagrees that governments are themselves monopolies, as well as the source of monopolies.

A more relevant example is a company that dumps its product on the market. This happens, and such companies sometimes face penalties for it. But in spite of the antitrust priests’ claims, that isn’t a monopolistic practice. Dumping is a loss to the company. The reason they do it is *not* to build market share, but to cut their losses following a production error leading to overly large inventories. This is common in technology where a company plans to sell a certain volume of a product only to be faced with a new technology making their inventories obsolete.

And then such companies, in addition to paying the costs of their own mistakes, usually face government anti-dumping penalties as well.

Joshua April 6, 2011 at 10:18 am

You note than no SANE company would pursue a predatory pricing strategy.

But if the funding mechanism for a company is insane, it may well be rational for its executives to pursue strategies that are not profit-maximizing.

Take the example of a public company or of a VC-funded company that is being steered towards an IPO. Suppose that the stock price of this company is valued far more as a function of revenue or market share growth than as a function of growth in profit. Suppose further that this growth function may be only loosely tied to the likelihood of obtaining a net higher profitability over time.

This would (and does) have the effect of encouraging behavior, including pricing, that is just stupid from a profitability perspective, but because stock price has become largely untethered from demand for profitability, due to investor psychology, etc..

I don’t leap from this observation to the notion that the government should step in to prevent it. But the fact that it happens, and that it may not be an optimal market outcome, I think is real.

vikingvista April 6, 2011 at 1:05 pm

Suboptimal market outcome is one thing. Sustainable monopoly is another. Free markets are not always optimal, but their incentives do tend to punish suboptimal behavior. Companies will make mistakes–take actions against their own self interests. One such mistake would be predatory pricing.

PrometheeFeu April 6, 2011 at 10:25 am

@Frank33328:
“dumping” as you describe it can indeed exist. But that would generally be a “good” thing from the point of view of foreign consumers. The “problem” with predatory pricing is that after your competitor was driven out of business, you will raise your prices to monopoly pricing levels thereby harming consumers. If you are able to constantly lower your prices because your government is funneling you tax-dollars as a subsidy this is, from a consumer point of view, nothing more than a permanent price drop which is a Good Thing(TM). Of course the citizens of your country are getting screwed out of their money through higher taxes, but that’s a different problem.

Frank33328 April 6, 2011 at 11:09 am

True; however, this is why I originally asked about the condition assuming that there is a high barrier to entry. Once the prey-country’s industry is destroyed, the predator-country’s industry would be able to charge higher monopoly level pricing. The predator-country’s industry could cut pricing, as needed, to discourage potential prey-country competition and the high barrier to entry, whether due to capital or lead time, would give the predator-country’s industry the time-buffer needed to play the game of adjusting pricing to keep competition from gaining a foothold.

BTW, this is an argument often put to me that I have never been able to answer well. Also, the real life example was the “dumping” of computer memory by Japanese firms in the mid-1980’s. The example in this case ultimately failed but I am not sure that I could explain why.

John Dewey April 6, 2011 at 2:03 pm

Can you give an example of an industry which has a barrier to entry so high that your hypothetical example woulf work? Did the Japanese achieve a sustainable monopoly in the computer memory industry? As you pointed out, they did not. I don’t think the barriers to entry in the computer memory industry are very high.

Frank33328 April 7, 2011 at 12:48 pm

My example would have been the Memory Industry in the mid 1980s where the capital equipment was both expensive and had long lead-times, and where the specialized training required of the work force would create such a condition. As pointed out, Japan is did not achieve world dominance in that industry. So if your point is: in theory I can invent barriers so high that dumping “could” work; however, in practice the barriers to entry can never really be that high – then I can accept this answer though it is unsatisfying. Certainly, those on the other side of the isle will claim that the reason it’s never worked as that the appropriate trade barriers were in place and that is why the dominate-through-dumping didn’t work.

kyle8 April 6, 2011 at 5:37 pm

Dumping occurs but I don’t know (maybe someone can help me out) When it has ever worked. A nation may be able to destroy an industry in another nation, but will lose out to a third nation because the only way you can have massive dumping is if the government is involved and that costs high taxes to achieve.

Arthur Felter April 6, 2011 at 12:53 pm

I just learned about oligopolies and predatory pricing in my micro-economics class this last week. In the class the teacher explained that one of the barriers-to-entry in a market is brand loyalty. I see predatory pricing being effective in preventing a new firm from establishing any sort of brand loyalty necessary to survive in the market.

Would you agree?

Bruce April 6, 2011 at 12:56 pm

If that were true, we’d still be driving Plymouths and Mercurys instead of those strange new Toyotas and Datsuns (sic).

Arthur Felter April 6, 2011 at 1:03 pm

So my professor used the example of Independence Air which tried (and failed) to succeed in offering low-cost flights. He mentioned that it failed because the other airlines used predatory pricing practices and Independence was unable to establish brand loyalty. Cause lets face it, if I’m loyal to American Airlines (for example), and AA’s flights are the same cost (or lower) than IA’s, why would I fly with IA?

vikingvista April 6, 2011 at 1:08 pm

I think you need to show your professor this list.

John Dewey April 6, 2011 at 2:56 pm

I wonder where your professor gained his knowledge of the passenger airline industry.

The U.S. passenger airline industry is extremely competitive. Fares in the U.S. are changed hourly in response to competitors’ promotions. Fare wars are not examples of predatory pricing but rather evidence of pure, simple competition.

Here’s other reasons – reasons your professor probably didn’t mention – that caused Independence Air to fail:

1. extreme over-capacity throughout the airline industry at exactly the time that Independence lost its alliance with United;
2. steep and unanticipated rise in jet fuel costs from 2003 to 2006;
3. continued expansion of low-cost Southwest Airlines at BWI;
4. use of 50 seat, high-cost-per-seat regional jets in markets where its rivals were using larger aircraft;
5. inability to provide a credible business model, which led to inabiity to attract capital;
6. the attempt to use of below cost pricing to attract customers.

Based on what I’ve read, I’d argue it was Independence Air – not its competitors – which initiated the low fare wars. Indepndence Air was offering fares lower than the large airlines to gain market share. The larger carriers simply matched the fares Indepndence promoted.

John Dewey April 6, 2011 at 3:11 pm

Incidentally, please consider the rise of Southwest Airlines from tiny regional carrier to the most profitable of all U.S. airlines. That fact is strong evidence that large airlines cannot squash smaller rivals by offering predatory fares.

Southwest continues to gain national market share while the legacy carriers continue to shrink. That fact should tell us something about how much loyalty customers feel toward their incumbent carriers.

SheetWise April 6, 2011 at 6:19 pm

Southwest is a bad example. They became a successful airline by flying intrastate during a period of strong airline regulation. They were, essentially, the only airline competing in a free market — and airlines that flew interstate were not allowed to compete with them.

A better example would be Laker Airways which was, by many accounts, put out of business by predatory pricing — selling dissimilar services at a loss, and calling it “competitive” pricing.

John Dewey April 6, 2011 at 7:22 pm

Sheetwise,

Southwest Airlines had very strong competition in its pre-regulation days. Frank Lorenzo’s Texas International Airlines had an extensive intra-Texas network. TIA’s revenues were larger than Southwest’s for most of the 1970′s.

Southwest Airlines was still a tiny airline when the industry was deregulated in 1978. Southwest’s revenues did not reach $50 million until that year. That was a drop in the bucket compared to the revenues of the major carriers which gained the freedom to start competing with Southwest that year.

SheetWise April 6, 2011 at 10:44 pm

I spent a lot of time on both TI and SW in the mid to late 70′s — and TI never matched SW fares, as TI was doing a lot of interstate milk runs. When deregulation came, it was near impossible for most carriers to meet the start-ups price structure as they were locked into contracts that were negotiated under regulation. Southwest was in a unique position to grow as its competitors were looking for ways to scale back. It’s interesting that SW was helped by regulation (it didn’t have to follow), and then by deregulation (that confounded competitors used to regulation). I don’t know if you can plan that kind of scenario — sometimes I think it’s best to simply be in the right place at the right time.

John Dewey April 7, 2011 at 4:12 pm

Sheetwise,

Not sure why your experiences in the 1970s led you to believe that Southwest did not face intense competition. I’ve worked in this industry for many years, and known well people who were directly involved in that competition.

Although the CAB prevented some interstate airlines from competing in Texas, a few were allowed to do so. Braniff and Texas International were especially fierce competitors on routes between Dallas, Houston, and San Antonio. Continental and Eastern were competing in the Houston-San Antonio market.

Both Braniff and Texas International heavily engaged in price wars with Southwest Airlines in the 1970s. Here’s two of a number of pieces of evidence I can provide:

In the Southwest Airlines headquarters building one can find the quote from co-founder Lamar Muse about which Southwest employees are so proud:

“Nobody is going to shoot Southwest Airlines out of the sky for a lousy $13.”

That quote was in response to Braniff’s half-price fare of $13 in their attempts to undercut Southwest in Texas markets.

In February, 1975, Braniff and Texas International were jointly indicted by the federal government “on charges of conspiracy to put Southwest out of business which violated the Sherman Antitrust Act”. That indictment was based on large part on the costly rate cutting practices the two airlines had simultaneously initiated.

Not meaning to sound condescending, but if you have not worked in the airline industry for the past three deaceds, you are likely unaware of many facts about Southwest’s uphilll struggle. I could provide more examples of the fierce competition Southwest faced both in the 1970s and for the three decades afterward. But, quite frankly, I don’t think continued debate about this issue will interest Cafe Hayek readers.

SheetWise April 8, 2011 at 2:26 pm

It’s good information John. My experience with TI and SW was when I lived in Houston 75-78, so I missed that early part. Between the two I flew at least a dozen legs a week, and during that period there was nothing close between the two — in price, equipment, or attitude ;)

Thanks for the history.

dan April 7, 2011 at 3:40 pm

Allegiance Air…..seems to be doing fine. Operates out of the lesser know and lesser used airports.

Aten April 6, 2011 at 1:08 pm

Actually I can give a real world example of predatory pricing. Netscape was selling a web browser and having great success as a company. Microsoft was very worried about the growth of the internet and spent millions to quickly develop their own web browser. After completing their browser they decided to give it away for free in order to bankrupt Netscape. The strategy worked perfectly.

vikingvista April 6, 2011 at 1:16 pm

I used both Netscape and IE. I seem to remember them both having the same price–free. I also remember ultimately liking and therefore using IE more.

This is an example of free competition, not monopolistic practices.

Aten April 6, 2011 at 1:25 pm

Netscape only made theirs free in response to Microsoft.

vikingvista April 6, 2011 at 2:06 pm

Maybe they charged for commercial use, I don’t know. But I used Netscape from the start, nearly to the time FireFox was introduced, and I never paid anything for it. I also (at that time, at least) did not engage in software piracy.

Artemis Fowl April 7, 2011 at 10:36 am

Netscape was utter crap. It was such utter crap, that even free, people would rather have used the marginally less crappy IE. It was caused netscrape for a reason.

Netscape was free before IE even came out.

Aten April 7, 2011 at 1:00 pm

Your claimly is completely wrong. Netscape was not free before IE came out. This can be verified from a variety of sources, such as the following excerpt from Wikipedia:

“…with the availability of version 1.1 beta on March 6, 1995, in which a press release states that the final 1.1 release would be available at no cost only for academic and non-profit organizational use.”

And your quality claims are really not very relevant to predatory pricing. The fact remains that Microsoft gave away their product in an effort to wipe out a competitor.

robert_o April 6, 2011 at 3:52 pm

Microsoft may have driven Netscape out of the market by giving away IE for free, but it has failed to do so with other competitors who charged money for their browsers (eg: Opera).

Microsoft was never able to recoup any of the costs of IE, since they never charged anything for it. It’s a net loss to Microsoft (and the less efficient Netscape) and a win for the consumer in general, who got a new good for free.

Aten April 6, 2011 at 7:48 pm

I agree that it was probably a net win for the consumer. And government efforts to stop predatory pricing almost certainly do more harm than good. I was just pointing out the inaccuracy of Don’s claim. He claimed that predatory pricing never happens, and this is a very clear and relevant example of it. As you stated in your comment, they gave their browser away in order to bury Netscape…the very definition of predatory pricing. Obviously they made up some excuse for why they were giving it away, but the real reason was well known at the time and I don’t think it has ever really been disputed in any credible manner.

Henri Hein April 6, 2011 at 10:01 pm

I could not disagree more. IE is still free. It was not an example of predatory pricing. It was an example of Microsoft building something that surpassed what Netscape could offer, either in price or quality or a combination thereof. Nothing to do with predatory pricing.

Netscape made by far the most money on their servers, so one could argue that IE and free browsers ought to have been a benefit to Netscape. They failed to become profitable and squandered their advantages away. There is little evidence they would have been viable even without a competing browser.

brotio April 6, 2011 at 11:11 pm

My experience with Netscape was that it was a pretty good browser, until it started trying to be just like IE. Then it got slow, cumbersome, and illogical.

And then AOL bought it…

Aten April 7, 2011 at 1:09 pm

Are you willing to concede that they sold their product well below their cost? Did they do this in an effort to eliminate a competitor? If so, it meets the definition of predatory pricing. Failing to raise your prices above cost after achieiving your goal doesn’t do anything to prove that you did not engage in predatory pricing. Especially when regulators are watching your every move.

vikingvista April 7, 2011 at 3:03 pm

Their product was Windows, they charged for it, and they were profitable. Perhaps you’d like to also argue that Calculator and Chkdsk were sold below cost. Maybe the CD player in your new Toyota was sold below cost.

Henri Hein April 7, 2011 at 3:15 pm

Vikingvista already made a strong point I agree with, but further:

“Did they do this in an effort to eliminate a competitor”

No. Netscape’s core business was their server software, and the browser wars was not about the server. It was mostly a technology battle. Microsoft wanted there to be a web browser demonstrating the core Windows networking libraries. They offered Netscape to build such a browser. Netscape declined, because they wanted a cross-platform browser. So Microsoft built their own browser.

How you find a predatory pricing motive in that scenario is beyond me.

Aten April 7, 2011 at 7:07 pm

So Vikingvista is arguing that IE was just an add on to Windows. Similar to Calculator or Chkdsk. Or like Toyota including a CD player with my new car. Hmmm…sounds like a pretty good argument. So, how much did Microsoft charge for the Mac version of IE? Oh, it was actually free as well. Kind of like Toyota giving me a CD player for my Honda. Maybe not the best argument after all.

And Henri Hein has a pretty good story, but it is mostly revisionist history. People forget how worried MS was about the rise of Netscape and the possibility that the browser could marginalize the OS. Microsoft was not in the habit of giving away major new software releases. It was clearly a competitive action, not a coincidental start of a new strategy. And the reasons for this strategy are pretty well documented. Can you site a source for your statement that browser revenues were insignificant to Netscape?

Michael April 7, 2011 at 5:04 pm

The point of predatory pricing isn’t simply to drive a competitor out of business, Aten–it’s to drive them out of business so the predator can charge whatever they please for their product.

This hasn’t happened with IE.

Nemoknada April 7, 2011 at 5:48 pm

“This hasn’t happened with IE.”

That assumes that the customer is the end user. Think of the ballgame that we get to watch for free on broadcast television. Are we the customer? Or are we the deliverable?

I’m not sure what the economics of the browser wars are, but it obviously matters to MS that IE be the Windows user’s browser. The reason may have nothing to do with what MS can charge users. But I’ll bet it has a lot to do with what MS can charge someone for something, and that’s all that counts.

dan April 7, 2011 at 5:56 pm

‘to drive them out of business so the predator can charge whatever they please for their product.’- Michael
Not saying this is a true or false statement…….only asserting that ‘charging whatever they please for their product’ needs clarification.
Me thinks that statement needs revising. They can charge a higher price to the point of what the market will bear. There is a limitation to the pricing. Too high of a price, and consumers will be driven to spend their money elsewhere. But, indeed, they would be able to charge higher prices since their main competition has been driven out.

Michael April 7, 2011 at 6:24 pm

Nemoknada,

That’s a lot of speculating. Without knowing who MS is charging for what, your objection doesn’t carry a lot weight.

Dan,

You’re correct the phrasing was clumsy on my part.

What I mean to say is that predatory pricing, as a strategy, only makes sense if the predator can, after its competition has been eliminated, charge prices sufficient to cover the losses of undercutting said competitor–otherwise, the predator loses.

Downsize DC April 6, 2011 at 1:29 pm

There’s an old joke that circulated a few years ago:

Three guys are in a jail cell. They start to talking and find out that they’re all gas station owners.

The first one says, “I set my prices at a couple of cents higher than my competitors. I’m in here for price-gouging.”

The second one says “I set my prices at a couple of cents lower than my competitors. I’m in here for predatory practices.”

The third one says “I set my prices at the same price as my competitors. I’m in here for collusion!”

Artemis Fowl April 6, 2011 at 1:56 pm

Predatory pricing cannot work. One has to look no farther than public schools, which have engaged in predatory pricing for years by offering their product at an impossible cost. Yet somehow private schools still manage to exist.

Methinks1776 April 6, 2011 at 5:12 pm

Oh, I think the cost of public schools can be higher than you’re imagining!

Artemis Fowl April 7, 2011 at 10:36 am

The cost to the consumer is free.

dan April 7, 2011 at 3:07 pm

What ‘cost’…….to what what ‘consumer’…………and nothing is ‘free’.

Methinks1776 April 7, 2011 at 4:24 pm

I beg to differ. The cost to the consumer is, in most cases, the time wasted to get a crappy “education”.

E.G. April 6, 2011 at 3:49 pm

Are we ignoring production limitations here? This strategy would be suicide for any manufactured good.

Doesn’t that just cause the demand curve to bulge to the right? I don’t necessarily steal customers from the competitor as much as I create new customers for myself, especially in markets with differentiated products, and especially if my production capacity is limited. Demand increases, and I can’t meet that demand with my current production capacity…The result is you reduce quality and brand as you struggle to meet demand in the short term, but with no guarantee that you steal customers from you competitor.

Where does differentiation and customer needs distribution play into this? The model of predatory pricing sounds like its based on commoditized products, or companies selling identical products in identical locations on a customer distribution, with inability to move up or down market…and with no limitations on expanding capacity.

SheetWise April 6, 2011 at 7:36 pm

There’s something missing in this discussion. I’m reminded of Gillette’s strategy, “give them the razor, sell the blades” … which seems to be the foundation for all printer manufacturers, “give them the printer, sell them the ink/toner.” The problem with that strategy, I believe manufacturers are learning, is that there is always some new printer on the market that is virtually free — and consumers will switch. People generally don’t have a lot invested in their printers, in time or money — so they are essentially a commodity. So if we’re talking items like canned peaches, or printers, they are somewhat fungible. Cars are as well, to a large degree, because they all do the same thing and it doesn’t take much time to adapt to a new model.

But the same is not true for computer operating systems, or any other software. Any user, whether they buy their systems or get them free, by the time they know how to use them will have a LOT more invested in time than the system originally cost. Originators of software gain a lot from getting users on the upgrade path, because the cost of switching from Publisher 8 to Publisher 9 is minimal, while the cost of switching between Publisher and InDesign is huge — as is the cost of switching between WordPress and Movable Type. You also don’t see a lot of migration between Apple and Windows users. Developers recognize the investment users make in their products, and also understand that it’s unrecoverable unless you continue to use the product. Since the marginal cost of delivering a software package to a new user is zero or less (often the adds on the download page more than cover the bandwidth cost), it makes sense to give it away free, functional for enough time that the user is invested far beyond the cost of the purchasing the software. Then there are the issues of finding skilled users and interoperability — which pretty much dictate that there are only going to be a few winners in every market segment, as the barriers to entry keep going up as the current users become more invested in the software they’re using. It’s clear in almost ALL software segments that the most popular among users are NOT the best OR the cheapest — they’re the ones that arrived at the right time.

I think there are two different models — one for fungible goods that consumers are indifferent to, and one for non-fungible goods that consumers are invested in. The argument in the OP, in my opinion, only covers the first. And since our economy is increasingly dominated by IP, I think the second model is more important.

Alex April 6, 2011 at 8:28 pm

So, the majority of my economic education comes from this blog and Russ’s podcast, so forgive me if this is too basic.

How does Don’s interpretation take into account the possibility of ‘predatory’ investors? You could have either one very rich investor or a cabal of smaller lenders, investing in a single firm in hopes of monopolizing that industry. Once a monopoly is achieved, they would certainly enjoy a return on their investment.

Take the airline example. If one firm successfully drives out all others, and then raises its prices, the investors of that business would profit. This could create the possibility of new airlines emerging by providing a cheaper service. However, the initial cost of purchasing airplanes/terminal space etc, would probably necessitate a much smaller market. The monopoly could just prey in the limited-sized market to eliminate the new competition.

I could see if investors would band together to construct a new company de-novo, however in the case of airlines, the initial cost of doing that seems unrealistic.

I’d love to hear your thoughts.

Sincerely,
-Alex

Methinks1776 April 6, 2011 at 9:38 pm

Alex,

I don’t think you will ever find an investor (and certainly not a group) who is willing to burn cash in the hopes of simply driving out other competitors in an undifferentiated product. But, if you do….

What happens when seven small airlines start up in seven regions in the United States? Your monopoly is not competing in one new market at a time, but potentially in many new markets at the same time. Competitors are mostly likely to challenge the monopoly in its most valuable routes. Now, the monopoly is forced to maintain its least profitable routes and engage in loss creating predatory pricing on its previously most profitable routes to maintain its monopoly. It could, of course, drop the least profitable routes, but that only offers a chance for a competitor to enter those markets and the monopoly is done.

Investors tend to stay away from negative expectancy investments.

Alex April 6, 2011 at 10:30 pm

So, in order for this to work, you’d have to have multiple entities working together, in a coordinated fashion, to stifle competition, right? I mean, for example, you could make it difficult-to-impossible to buy planes, rent terminal space, etc. So is there an example of this happening in the ‘free market’?

Well, sure. Correct me if I’m wrong, but wasn’t that exactly what happened in the agri-business? The even that triggered the critically-acclaimed book and movie staring Matt Damon to be made.

Methinks1776 April 7, 2011 at 8:25 am

The critics acclaim many falsehoods. I don’t know what you’re talking about – I’m just not familiar with that story.

dan April 7, 2011 at 8:57 pm

Govt involement.

dan April 7, 2011 at 3:13 pm

DTW- Detroit Airport
Northwest has priority on terminals and gate availability. They, also, get a vote (they get to determine competition) on requests for another airlines access to ‘gates’. Northwest can veto a Southwest request for access to another gate. Part of a deal made when Northwest ‘contributed’ to the expansion of DTW. In my opinion, this is an unfair practice. They did ‘invest’, and are looking out for their ‘investment’, but they can easily reject competition by authority of DTW rather than beat them out in the market.

Alex April 8, 2011 at 11:07 am

So this would argue for a level of regulation, then?

John Dewey April 7, 2011 at 6:02 pm

Since the 1978 deregulation, it has been very difficult for an airline to sustain a monopoly in a profitable market (an origin and a destination). Of course, governments can still find ways to restrict competition. For example, Southwest Airlines is still – until 2014 – restricted to flying nonstop to only a few states from Dallas Love Field. Another example – though I’m not familiar with the details – is the situation at Detroit which Dan notes in his comment to you.

What does work in the U.S. airline industry is efficiency. Southwest Airlines – the most unonized of all U.S. airlines – manages to keep its costs lower by achieving much higher utilization of assets and employees. Basically, the airline keeps its airplanes and its pilots in the air, earning revenue, more hours per day. Southwest has been able to dominate many U.S. markets through lower prices. That’s efficiency diven lower prices, not predatory lower prices.

dan April 7, 2011 at 6:07 pm

I welcome corrections/additions to my notes on DTW and Northwest. But, make no mistake, Northwest, through their ‘investment’, has the ability to restrict other airlines access to gates. I cannot remember the details. Which is why I tried to be careful with my statements and will not look to further elaborate.

dan April 7, 2011 at 6:12 pm

Take notice of pricing to Detroit as opposed to other nearby cities. While airports are not all equal, and their pricing structures is most likelyThe pricing of overhead costs or perogative, DTW is noticably higher than other destination cities. Coincidence? NO!!!!
Northwest dominance hurts the competition in DTW.

dan April 7, 2011 at 6:15 pm

Ha, I remembered something…..the above statement.

ettubloge April 7, 2011 at 9:10 am

When there is free competition, Hayek advises, just the threat of a new-comer forces the established entrepreneur to keep prices as low as possible. In such an environment, he must recognize that the “gouging” will be fleeting (and perhaps remembered by some customers going forward). But we also need bankruptcy to allow the defeated company’s assets to be sold to the new-comers at the fire sale price. This reduces the initial capital outlay and allows the new-comer to enter the market.

A free market makes so-called monopoly/predatory pricing a losing venture.

dan April 8, 2011 at 1:45 am

I don’t know of any ‘new-comers’ in the Auto industry, but certainly, Ford got cheated out of gaining significant market share by govt interference. Maybe, Hyundai would have gotten their shot to rise in market share and gain on Honda and Toyota. And I am sure all here can elaborate more into this venture of discussion……… The point is to agree with post 79 on the defeats of a company in an industry, whether by the strains of a recession or that of hardball tactics in competition.

Nemoknada April 7, 2011 at 9:55 am

This article reminds me of Xeno’s paradox – a “logical” argument about how the fast runner never catches the slower one. Then you look at the finish line and are surprised to see who won the race. Predatory pricing was a tactic of the Oil Trust. It doesn’t matter how stupid and undoable it was. It was done. It happened. Here, in the US of A. Get over it.

But there is no paradox, as DB’s argument is full of holes. Here’s just one. The pay-off in rent for a monopolist who maintains his monopoly is greater than the pay-off for a competitor whose survival merely creates a competitive space. To justify spending what the monopolist is willing to spend, the competitor must, therefore, not just survive, but must put the existing king of the hill out of business And we’re to believe that outside investors – a bank, no less, not even speculating equity types – will put up a credit line sufficient to bankrupt a thriving monopolist that has unlimited funds that is has already amassed in the relevant business? On what planet?

How can we assume that a potential victim of predatory pricing is “as efficient” as an existing monopolist? When did it work the bugs out? When did it achieve scale? It’s a freakin’ start-up. How on earth can it be assumed to be as efficient as an existing monopolist? (Yes, it can have a better mousetrap, but then predatory pricing would fail because price isn’t the basis for competition, not because predatory pricing is inherently “suicidal.”) More important, why would investors believe that the competitor will succeed? And not just believe, but believe with the confidence that it takes to invest enough to bankrupt the existing monopolist. According to DB, all the new guy has to do is “promise” to succeed. Yeah, that’s the ticket.

And you still doubt that DB is a liberal parodist?

CalgaryGuy April 7, 2011 at 11:20 pm

Wouldn’t the potential victim of predatory pricing have to be “as efficient” as the predator? If they were less efficient than the predator, then the predator wouldn’t need to offer products below it’s cost, it already has a price advantage.

Nemoknada April 8, 2011 at 1:47 am

“Wouldn’t the potential victim of predatory pricing have to be ‘as efficient” as the predator?”

The monopolist would be silly to wait around to find out. A new guy hangs up a shingle, the monopolist lowers his price to where the newcomer can’t compete, and efficiency becomes academic. I was really addressing the idea that the newcomer would find it easy to find money to take on the monopolist. Persuading the money men that you WILL BE as efficient as the monopolist is hard. Add that you will have to endure a price war that the monopolist has more to gain from than you do, and the money dries up.

I suspect DB’s assessment of the newcomer’s access to money is tainted by anachronism. We are talking about LEGAL predatory pricing, i.e., predatory pricing in a world without those pesky antitrust laws. Looking around in 2011 at a world awash in cash, with all of the protections afforded start-ups against monopoly depredations, it may seem easy to raise money than it would be without those protections. But this is now, and that was then. In a world where predatory pricing is legal, capital will find better risks to take than shooting at the king.

John Dewey April 8, 2011 at 7:06 am

A few comments on points raised by nemoknada:

“To justify spending what the monopolist is willing to spend, the competitor must, therefore, not just survive, but must put the existing king of the hill out of business “

Why? Southwest Airlines was very successful in challenging larger rivals in a number of markets without putting those larger airlines out of business. Many other small companies have learned how to slice off a niche from a bigger rival.

“How can we assume that a potential victim of predatory pricing is “as efficient” as an existing monopolist?”

The new entrant to a market isn’t always as efficient. But it very often is. Monopolies and oligopolies have an amazing tendency toward wasteful spending. In many industries, economies of scale often get submerged by a tide of corporate bureaucracy.

“When did it work the bugs out?”

New startups are often founded or partially led by experts who have years of experience in the industry. That’s certainly been the case in my industry. Southwest Airlines first CEO, Lamar Muse, had previously been an executive at American Airlines. Years later, JetBlue was founded and led by several leaders recruited from Southwest Airlines.

“More important, why would investors believe that the competitor will succeed?”

Venture capitalists do not have to succeed on every investment. Furthermore, successful venture capitalists are experts at identifying those startups which have an acceptable chance of success.

Nemoknada April 8, 2011 at 8:06 am

“Southwest Airlines was very successful in challenging larger rivals in a number of markets without putting those larger airlines out of business. ”

SWA was not facing a monopolist in a world without antitrust laws. So how is its experience relevant?

Moreover, DB’s point was that the monopolist would have to spend more than the newcomer on the price war. My response was that the monopolist had more to gain from preserving its high-margin monopoly than the newcomer does by establishing low-margin competition, so it makes sense that the monopolist be willing to spend more than the newcomer unless the newcomer sought a monopoly, too.

“[S]uccessful venture capitalists are experts at identifying those startups which have an acceptable chance of success.”

Which is why they they would not so identify any newcomer going up against a monopolist in a world without anti-trust laws. At least not enough to make predatory pricing a losing strategy for your average monopolist. That there might be outlier exceptions hardly establishes the futility of the strategy.

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